Investment Decision: Weighted Average Cost of Capital

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Investment DecisionWeighted Average Cost of
Capital
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Return on assets must be greater than the cost of
capital
Current Liabilities
Current Assets
What is the cost of financing? (What does it cost
to use the bondholders and the stockholders
money?)
Long-Term Debt
Fixed Assets Tangible Intangible
Shareholders Equity
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Why Study Cost of Capital?

• 1. Capital budgeting decisions
• 2. Regulated industries
• 3. Leasing, bond refunding, working capital
• 4. Maximize value or minimize cost of inputs,
  including capital

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Why a Weighted Average?

• Cost of debt RD 8
• Cost of equity RE 12
• Project A
• IRR 10
• Financed with all debt
• Project B
• IRR 11
• No debt available
• Financed with all equity

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Weighted Average Cost of Capital Assumptions

• 1) New projects risk equals existing projects
  risk
• 2) General financing policies are not affected by
  the particular project

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Weighted Average Cost of Capital

• RA RD (1-t) wtD RP wtP RE wtE
• Where
• RA weighted average cost of capital
• RD cost of debt
• RP cost of preferred stock
• RE cost of equity (common stock and retained
  earnings)
• wtD weight of debt D/V
• wtP weight of preferred stock P/V
• wtE weight of equity E/V
• t marginal tax rate

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Cost of Debt, RD

• Use the marginal cost of debt
• A proxy for the marginal cost of debt is the
  current yield to maturity (YTM) on bonds
• After tax cost of debt (YTM)(1-t)
• EAR is best.

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Cost of Debt Example
Market value of issue Years to maturity Coupon
rate (annual payments) Face value
18.75 million 8 years 5 20.00 million
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Cost of Debt with Multiple Issues (tax rate is
46)
Step 1 YTMs a 6 b 6 c 7 Step 2 Weighted YTM
Step 3 Tax Adjustment RD 6.6 (1 - .46)
3.6
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Cost of Preferred Stock

• 1. RP return required by investors to invest
  in the firms preferred stock
• 2.
• 3. No tax savings on dividends

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Cost of Preferred Stock Example Book value of
issue 24 million Market value of
issue 20 million Preferred dividend
(annual) 2 million
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Cost of Preferred Stock with Multiple Issues
Step 1
Step 2
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Cost of Equity or Required Return

• Cost of Equity is not always a cash outflow it
  can be expected growth (appreciation).
• Retained earnings have an opportunity cost--stock
  holders could have received the earnings and
  invested them in alternative investment of
  comparable risk--RE
• Methods of Calculation
• Historical
• Gordon Growth
• CAPM
• McQueens Quick and Dirty

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The Cost of Equity Capital
Shareholder invests in financial asset
Firm withexcess cash
Pay cash dividend
A firm with excess cash can either pay a dividend
or make a capital investment
Shareholders Terminal Value
Because stockholders can reinvest the dividend in
risky financial assets, the expected return on a
capital-budgeting project should be at least as
great as the expected return on a financial
asset of comparable risk.
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Cost of Equity--Historical Estimate

• Rate of return is made up of dividends and price
  appreciation
• To get a good historical rate, find the actual
  rate for several recent years and arrive at some
  sort of average.
• Implicit assumption expected return equals past
  returns

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Cost of Equity -- Historical Estimate Example

• Questions
• Is the expected required return 40 or 20 or
  some average?
• Is the increase to 40 a trend?

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Cost of Equity--Gordon Growth

• 1. Assumption dividends will grow at a
  constant rate g
• 2.
• 3. Find g
• a) historical dividend growth
• b) sustainable growth

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Finding g for ke Calculation

• 1. Historical approach
• (1993 DPS)(1g)10 (2003 DPS)
• .56(1g)10 1.75
• g 12
• 2. Sustainable growth Where
• SG (ROE)(1-PO) ROE Return on Equity
• (24)(.5) NI/OE
• 12 PO Payout Ratio
• Div/NI
• Arithmetic average is better than geometric
  average when forecasting.

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Finding Cost of Equity--Example

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Cost of NEW equity

• F Flotation costs per share of new stock

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Summary of Components
EAR is better
Notice RD lt RP lt RE
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Cost of Capital Weights

• 1. Best Proportions of individual source inputs
  the firm intends to use in the future or target
  weights
• 2. Proxies--
• a) Book value weights
• b) Market value weights

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Weighting the Components(No new stock issues
planned)
Market Weights
Book Weights
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Key Assumptions of RA

• 1. Same Risk
• 2. Same Financing
• Goal-- Find the discount rate associated with the
  risk of the cash flows

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Fundamental Rules

• 1. Match investment perspective to
• a. Cash Flows
• b. Discount Rate
• (i.e., After tax cash flow with RA and
• equity cash flows with RE)
• 2. Discount rate consistent with risk
• (i.e., The cost of capital depends primarily on
  the use of the funds, not the source.)

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Capital Budgeting Project Risk
Project IRR
The SML can tell us why
Hurdle rate
Firms risk (beta)
A firm that uses one discount rate for all
projects may over time increase the risk of the
firm while decreasing its value.